How To Get In and Out of an Outsourcing Deal

No one asks:"Why outsource?" any more. Since Kodak signed the first major IT outsourcing contract 12 years ago, even the most sceptical CEOs have come to realise that they can cut costs, improve service levels and gain access to better technology by placing at least some of their IT assets in the hands of a vendor.

But what's the right way to outsource? That's the trick. To master it, one must focus on two fundamental challenges: how to get into a good deal and, just as important, how to get out of a bad one.

How to Cut the Best Deal

Larry Godec, newly appointed CIO of California-based First American Title Insurance, is weighing a decision to outsource First American's help desk. It's a big decision, and he's taking his time. He's also taking advice from STI, an outside consultant based in Texas. Why hire a vendor to help make a decision about another vendor? Here are three good reasons.

When the typical IT shop outsources, it's often a unique experience for it. But outsourcing attorneys and consultants see these deals every day."They have experience in best practices," Godec says."They can compare what you're doing to what other people have done - what's succeeded, what's cost-effective and efficient." When Tom Boardman, CTO of San Diego County, outsourced the county's entire IT operation in 1999, he hired Gordon & Glickson, a Chicago-based law firm that specialises in IT outsourcing."They know what everyone else has agreed to in their contracts," Boardman says."Even if they can't reveal those figures, they can keep negotiating until they reach the point where the vendor has been willing to go in the past."

CIOs know what their IT organisation can and can't do, but typically they don't understand how the rest of the enterprise perceives their department. An outsourcing consultant interviews the users and helps establish an IT baseline - what are the current service levels and response times, and how do internal IT customers feel they are being served? It could be that your own IT organisation is already providing efficient service. Dennis McGuire, chairman and CEO of Texas-based Technology Partners International, one of the first and largest US outsourcing consultancies, says 30 per cent of his clients choose not to outsource after this initial baseline analysis. Prior to this analysis,"even relatively good IT organisations only know where 60 to 70 per cent of their costs are, and there are often no [established] service levels", McGuire says.

Everyone appreciates the importance of a contract in which you spell out the terms of the deal - how long and for how much. But equally critical is the initial RFP circulated to vendors. Here the consultant can combine knowledge of the marketplace with details about your company's needs and emerge with a document that spells out exactly what is to be outsourced and what results are expected. And it's not just the prospective vendor's expectations that are being set; so are the users', who need to know exactly how their life will change. When the US state of Connecticut attempted to outsource its IT operations in 1999, officials failed to spell out all of the terms of the deal in the RFP, and the prospective deal died in conflicts over service levels and costs. Boardman learned from this mistake when he negotiated San Diego County's deal."Success is determined in the RFP," Boardman says."An outside consultant can really help you determine what it is you're buying and what should go into the RFP. I won't say we couldn't have done it, but they did it a lot more efficiently and effectively."

How to Get out of a Bad Deal

Vendors like to say that outsourcing deals are like marriages, and John Davis, vice president of purchasing, engineering and information systems at National Steel, agrees."Fifty per cent of them are breaking up," he says.

Davis knows. Since becoming CIO of Indiana-based National Steel in 1994, he's inked more than $US50 million in outsourcing deals with big-name vendors such as EDS and IBM. Today, Davis outsources everything but IT management - only eight of his 120-member IT staff are full-time National Steel employees. But not all of Davis's outsourcing relationships have been happily ever after. One - a seven-year, $US63 million deal with the former MCI Systemhouse signed in 1995 - ended in divorce. When MCI Systemhouse was acquired by EDS in 1999, Davis exercised his contract's change of control termination clause.

"We didn't do good due diligence, and they didn't either," Davis says about the dud deal."We didn't do a good job telling [MCI] exactly what we needed, and they were never able to perform the services we thought should be performed." It's never an easy decision to call it quits, but in National Steel's case the sting was eased by contractual provisions Davis built in that protected key assets and personnel that could have been lost in a custody battle. The lesson learned? CIOs needn't be slaves to their outsourcing contracts. But the key to freedom: don't just have an escape clause, have an escape strategy.

PLAN FOR THE END FROM THE BEGINNING. All outsourcing deals expire. Knowing this, spell out up front the exact terms for a full or even partial termination (in case you want to bring some functions back in-house but still outsource others). Gordon & Glickson Partner Mark Gordon recommends identifying which IT assets (hardware and software) and key personnel you want back when the deal ends, and what price you will be willing to pay to regain them. And be sure to track these assets and people in case the vendor reassigns them."Much easier to say than do," Gordon concedes, but worth the effort when the breakup arrives. The alternative, says Davis, is a lose-lose proposition. You know you can walk away from the deal, hurting your vendor, but your vendor knows it can walk away with your best people, wounding you.

BUILD KEY MILESTONES AND PENALTIES INTO THE DEAL. Rather than wait for contract-renewal time to assess the merits of the deal, build in milestones along the way - key rollout dates, transition targets or service-level goals - and marry them to significant penalties if they're not met."This way you can arrest problems right away rather than watch the deal crash and burn," says McGuire. And if the deal really is doomed to failure, you'll know sooner rather than later. Davis argues for including escalation clauses, which require top-management meetings between vendor and customer if milestones are missed consistently."These are effective because CEOs don't like to have to explain why their companies are failing," Davis says.

RESERVE THE RIGHT TO BRING IN A NEW VENDOR. First, resist the urge to outsource everything to one vendor. Once a single vendor has control of all your assets and personnel, you've lost the ability to disentangle cleanly if the deal falls apart. Plus, the price leverage afforded by having another vendor on the scene is especially powerful during renegotiations.

EXPECT PUSHBACK FROM MANAGEMENT.
Breaking up isn't just hard to do, it's expensive, especially when you start adding up the costs of buying back outsourced assets or rehiring personnel. In big deals, it's likely the vendor has developed strong relationships with your senior management. Anticipate management will push back if you want to end an outsourcing deal, and be prepared to present a solid business case to support the decision.

MAKE IT PAINFUL FOR THE VENDOR TO QUIT. There's a bait-and-switch tactic common in outsourcing deals: the vendor puts its A Team on the account during courtship then switches to the B Team (or worse) after the deal is done. To avoid that, and a resultant decline in service, CTO Boardman added an interesting wrinkle to his disentanglement clause with the Pennant Alliance, which holds a seven-year, $US644 million contract to run San Diego County's IT operations. If the county terminates all or part of the agreement because of failure to perform, Pennant must pay 20 per cent of whatever remains on the contract to the county or to the vendor that takes its place. Were this penalty invoked, Pennant would be in the position of writing cheques to a competitor."We really want to make it unpleasant for the vendor to walk away," Boardman says.

Incidentally, when National Steel's Davis terminated his contract with MCI Systemhouse/EDS in 1999, he did a new RFP, put it out to bid and ended up signing a new five-year deal . . . with EDS. The difference: this deal set the right expectations and terms, and EDS assigned a whole new management team to it."We've learned to do [outsourcing] right," Davis says.

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